The IMF therefore believes it is necessary for Sri Lanka to raise the rates for income tax, corporation tax and VAT, and to reduce exemptions. It sees a need for improved revenue administration, greater spending discipline, greater realism in formulating projections and, specifically, cost-recovery-based energy pricing, to restore the finances of SOEs such as Ceylon Petroleum and the Ceylon Electricity Board. It has added that current energy subsidies disproportionately benefit the rich.
Monetary and Exchange Rate Policies
Although monetary policy has been tightened from August 2021 and interest rate caps for T-bill auctions were removed in September, the IMF has commented that higher inflation has meant that real interest rates have been comfortably below the average of the last decade of +2.5%.
The IMF welcomed January’s 0.5% increase in policy rates, to 5.5% to 6.5%, as a “step in the right direction”, as well as the government’s plan to issue a regular Monetary Policy Report, to clarify the inflation-targeting framework. However, it has urged the Central Bank to phase out its direct financing of budget deficits on a time-bound basis, and to return gradually to a market-determined and flexible exchange rate policy.
In the IMF’s opinion, the projected current account deficit of 3.8% GDP is higher than is justified by fundamentals, and FX adjustment is needed to ensure external sustainability in the long term. It suggests structural reforms are needed to boost Sri Lanka’s export capacity and to encourage FDI into export-oriented sectors. Import restrictions and capital flow management measures are judged detrimental to economic activity and should be phased out.
Ensuring Financial Sector Stability
Prior to the pandemic, several measures were introduced by the Central Bank to strengthen regulatory and supervisory frameworks, and banks and licenced finance companies have, on the face of it, preserved capital, liquidity and profitability through the crisis. Reported NPLs have been stable, although the picture has been complicated by loan repayment moratoria and relaxed prudential requirements, which were introduced to relieve pressures resulting from the effects of COVID.
In the IMF’s opinion, the banks’ large exposure to the government and SOEs is a matter of concern, as it strengthens the sovereign-bank nexus and crowds out the banks’ ability to lend to the private sector. In addition, sovereign credit downgrades have constrained the banks’ access to external financing and import credit, amplifying FX shortages.
A credible macroeconomic strategy is therefore deemed essential for financial sector stability. The IMF has welcomed plans to phase out COVID relief measures, including the expiration of the repayment moratoria for individuals and businesses, and for the tourism sector by June 2022, but it believes the Central Bank needs to keep a close eye on the quality of loans exiting the moratorium, including through stress testing. It believes capital and prudential requirements should be restored to pre-pandemic levels “under a feasible timeframe”, and that restrictions on bank profit distributions will help to ensure capital adequacy.
In the IMF’s opinion, further action is needed to broaden the Central Bank’s regulatory powers and the resolution framework. The regulations for the banks and non deposit-taking institutions should be harmonised, and larger and more sophisticated institutions should be subject to tighter requirements.
Protecting the Vulnerable, Raising Potential Growth and Strengthening Institutions
The World Bank has estimated the $3.2/day poverty rate rose from 9.2% in 2019 to 11.7% in 2020. Earnings losses have been concentrated on the bottom 40% of households, thereby increasing income inequality, with the informal sector suffering from reductions in salary expenditure by MSMEs of up to 60% to 80%. In this context, the IMF judges that social safety net spending of around 0.4% GDP leaves significant room for improvement.
Sri Lanka’s population is ageing, and capital accumulation has been held back by the debt overhang and by macroeconomic uncertainty. The IMF believes decisive policy changes are needed to promote female participation in the labour force, to create job opportunities for the young, to reduce trade barriers and to improve the investment climate.
Trade and economic liberalisation are needed for greater export diversification into higher value areas and to increase productivity.
Specifically, the IMF is advocating a reduction in non-tariff barriers in sectors reliant on global value chains, and SOE reform. There are more than 400 SOEs in Sri Lanka, which play a significant role in sectors such as ports, energy, water, finance, retail, production of food, mining and construction. These have encouraged price controls, have distorted markets and have stifled competition.
According to the IMF, the Colombo Port City Project is an important opportunity for testing investment promotion and growth-enhancing structural reforms. The IMF has urged the authorities to ensure tax concessions are ring-fenced, to ensure compliance with international tax and AML/CFT standards and to shield domestic financial institutions from offshore banking activities in the Port City.
Finally, the IMF has argued that, with very limited fiscal space, continued efforts are needed to strengthen governance, and to reduce corruption vulnerabilities.
Response of the Authorities to the IMF’s recommendations
At the time for the report’s prepartion, the Sri Lankan authorities expressed agreement with several of the IMF’s arguments. However, there were a number of significant areas in which they disagreed.
Most obviously, they said that the IMF was being too pessimistic in its assessment of the 2022 budget and the Central Bank’s Roadmap, and they were much more optimistic that the short-term debt service challenge could be overcome by G to G co-operation, an improving current account deficit, & etc.
They argued against the need to raise tax rates, they viewed monetary policy as appropriate, and they disagreed with the IMF on exchange rate policy. It appears that the two sides were someway apart before the latest round of the current financial crisis struck.
The following table summarises the IMF’s expectations for the Sri Lankan economy at the time is prepared its report:
For the full text of the IMF’s report, please use the following link to its website.
https://www.imf.org/en/Publications/CR/Issues/2022/03/25/Sri-Lanka-2021-Article-IV-Consultation-Press-Release-Staff-Report-and-Statement-by-the-515737
